Victoria's Secret case tests U.S. manufacturing tax break

WASHINGTON, April 2 Tue Apr 2, 2013 5:02pm EDT

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WASHINGTON, April 2 (Reuters) - If an outside contractor makes lotions sold by Victoria's Secret, should the lingerie retailer known for its curvaceous models get to claim a tax deduction for manufacturing products in the United States?

That is the basic issue before the U.S. Tax Court in Washington, D.C., as L Brands Inc, owner of Victoria's Secret and Bath & Body Works stores, quarrels with the Internal Revenue Service over about $25.4 million in tax breaks.

At issue is what qualifies a company to claim that it is the manufacturer of a product it sells.

The case, still not scheduled for a hearing, could have implications for all sorts of companies that use U.S.-based contract manufacturers, said tax lawyers on Tuesday.

"Contract manufacturing is probably the biggest issue that is disputed between IRS and taxpayers" in audits focused on the domestic manufacturing deduction, known as Section 199, said George Manousos, a tax partner at PricewaterhouseCoopers.

Upcoming court rulings in this area are "going to be very influential," he said, with wins for corporations potentially opening the door to wider retroactive claims under Section 199, but IRS victories reducing the attractiveness of the deduction.

L Brands declined to comment on Tuesday, citing the pending litigation. The IRS also declined to comment.

L Brands was formerly named Limited Brands.

Enacted in 2004 amid concerns about manufacturing jobs leaving the United States, the Section 199 deduction was meant to bolster the U.S. manufacturing job base. Since then, it has become ubiquitous and claimed by a wide range of companies.

Publishers, mining companies and television production groups have claimed the deduction. The IRS has been aggressively auditing such claims, especially those involving third-party contract manufacturers, tax lawyers said.

IRS VS LIMITED

The IRS hit Limited Brands, based in Columbus, Ohio, with tax bills in 2010 and 2012 for claiming the deduction from 2007 through 2009, according to court documents.

The company's U.S.-based contract manufacturers made gels, creams and other lotions, as well as the packaging and labeling for them, following Limited's specifications, according to the company's 2010 and 2012 Tax Court filings.

The contract manufacturers, not named in court documents, were not owned by Limited Brands. But the company said it "controlled and monitored every stage of the production cycle."

Limited said it assumed "the benefits and burdens" of the manufactured products, which were ultimately sold at Victoria's Secret and Bath & Body Works stores. As a result, the company has said, it should get the Section 199 manufacturing deduction.

The IRS, however, has disputed that Limited Brands is a manufacturer under Section 199, according to court filings.

The agency said Limited did not communicate frequently with the contract manufacturers and did not control the raw materials used in the production process.

MEDIA AND MARKETING CHALLENGES

Valassis Communications Inc and Meredith Corp , both media and marketing businesses, are also challenging the IRS over contract manufacturing, documents show.

Valassis's case, which involves ADVO Inc, a business acquired in 2007, went to trial in May 2012. A court ruling in the dispute, over about $2.5 million of Section 199 deductions, could come this spring, Manousos said.

Meredith's dispute is not in court, but the company is challenging the IRS in the agency's internal appeals process.

Valassis and Meredith declined to comment.

The IRS last week ruled against an unnamed book publisher, saying it could not claim the deduction for income derived from the sale of books produced by a contract manufacturer.

Section 199 cost the Treasury Department $13.4 billion in 2012, according to a 2012 Congressional report. That cost to taxpayers is projected to rise to $16.4 billion by 2015.

Critics of the deduction call it corporate welfare and say it should be scrapped. Advocates say it is mostly claimed by manufacturers and it supports a vital segment of the economy.

An IRS win in court might discourage businesses from claiming the deduction, potentially driving jobs offshore, said Todd Reinstein, a partner with law firm Pepper Hamilton.

The case is Limited Brands Inc and subsidiaries et al v Commissioner of Internal Revenue. Docket Nos. 17903-10 and 14667-12. The Valassis case is ADVO Inc & subsidiaries v Commissioner of Internal Revenue. Docket No. 17247-10.

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